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Market Roundup - May 2014

May: Problems? Don’t blame earnings.

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist

The first quarter was a wild ride, though the dreaded correction—a decline of 10% from a peak—for equities didn’t come and a drubbing for bonds never transpired. You can blame the volatility on the weather or the Russians, just don’t blame it on the Federal Reserve (Fed) or earnings. Both still seem to be very supportive of an upwardly biased equity market and low interest rates. Why place blame when you can just ride out the volatility?

> The economy
> Equities
> Fixed income
> Asset allocation
> The bottom line

The economy: Barely growing is good enough for now

By Brian Jacobsen

First-quarter gross domestic product (GDP) advanced at a miserly 0.1% annualized pace, according to the advance estimate from the Bureau of Economic Analysis. If not for a surge in health care spending by households, economic growth would have been economic contraction. A lot of this surge in health care spending could have been due to the Affordable Care Act pushing more people to get insurance. Some of it could also have been due to people practicing a little catch-up medicine as the growth in health care expenditures slowed during the recession and even into this nearly five-year-old recovery.

Any given quarter’s growth could be due to infinite factors: It could be the weather causing a slowdown; it could be a buildup in inventories in the third quarter of last year that resulted in some payback; it could be a slowdown in exports thanks to difficult shipping conditions or slowness in export destinations; it could be a lack of investment as the expiration of accelerated depreciation provisions in the tax code shifted investment from 2014 into 2013; or, it could be just about anything else. But, the longer view is informative of where we’ve been and how far we’ve come and, perhaps, how much further we have to go.

Most GDP components still playing catch-up
Residential investment and nonresidential equipment collapsed from peak

Sources: Bureau of Economic Analysis and authors’ calculations

It’s no secret that housing and construction collapsed during the recession. Those areas are still a shadow of what they were. Spending on nonresidential equipment is just now back to where it started, even though the economy is producing 6.3% more in terms of goods and services than it was at the previous business cycle peak. This area—business spending on capital and equipment—is where we think we could see continued growth.
Personal consumption expenditures (PCEs), which make up 68% of GDP, have been propelling the economy forward, and that force doesn’t appear to be abating. Yes, faster growth in personal spending likely will require faster employment growth or more rapid wage gains, but spending has been resilient, even with subpar labor market gains.

Ignore the inflation scaremongers

On the inflation front, there is a lot of talk about whether there will be an inflation scare in the months ahead. Sure, there could be, but we think it is unlikely to be that frightening. The inflation scaremongers assert that a pickup in inflation could make investors panic that the Fed will overreact by raising rates sooner rather than later. First, we think you have to assess the likelihood that inflation will rise to a level that is substantially above the Fed’s target. Second, you have to ask whether the Fed would actually react by raising rates or if it would view the rise as being transitory.

All the evidence suggests that it is unlikely that inflation will accelerate well above the Fed’s target of 2% on the PCE Price Index. If you actually look at the component parts of the Fed’s favorite price index—the PCE—you will see that prices are still a little short of where the Fed probably would like them to be. Some components, especially the “other durable goods” category, are well short of where they would be if all prices had risen at 2% annually since the fourth quarter of 2007. In fact, all prices don’t rise together. You get some—food and energy, for example—that are driven by a lot more than monetary policy. Others, such as health care and education costs, tend to go up in price faster over time than other categories, eating up an ever-larger share of people’s spending. As a whole, however, average inflation since the third quarter of 2012, when the Fed started its latest asset-purchase program, has advanced at a rate of 1.2%. In the first quarter of 2014, prices rose at an annualized rate of 1.4%. The Fed’s target is 2.0%; there’s still a ways to go to get there. With private-sector credit creation still anemic and unit labor costs making paltry gains, there is not a lot of inflationary pressure building up.

PCE components don’t appear to be creating inflationary pressures
Parts are growing at different rates, but none faster than the Fed would like

Sources: Bureau of Economic Analysis and authors’ calculations

Hypothetically, let’s say that because of rising health care costs and slightly faster growth in housing and utilities expenses, inflation does start to go above the Fed’s target. Would the Fed react? Would the Fed overreact? Every other time a component part of inflation has increased rapidly, the Fed has downplayed it as transitory. It’s easy to do that with food and energy prices, which tend to revert after a run-up, but it’s harder to do that with health care and housing costs. Health care makes up approximately 17% of the PCE Price Index and housing makes up approximately 18% (compared with 7% and 41%, respectively, for the Consumer Price Index), so they are important to inflation. However, they are not the whole story when it comes to inflation. Health care costs have been rising significantly faster than overall prices for quite a long time. For housing, home price appreciation seems to be slowing and mortgage financing costs are still very low. It would take a lot for these two to be the culprits in pushing inflation above the Fed’s target.

India’s time in the sun

Before we are inundated with midterm election coverage in the U.S., it’s vital to remember that there are a number of important elections this year outside the U.S.: South Africa’s election for National Assembly is on May 7; the European Union’s election for European Parliament is on May 22; on May 25, there is the election for president in Ukraine, which could see escalating tensions in the run-up; Colombia’s presidential election is on May 25; and Afghanistan and Egypt are having presidential elections on May 28 and 26, respectively. These are all important, but perhaps the most important one will be the election results to be announced on May 16 from the largest democracy in the world: India. Narendra Modi, head of the opposition Bharatiya Janata Party (BJP), is ahead in the opinion polls. A BJP victory likely would spell significant pro-growth reforms.

Equities: Geopolitics rule short term, but earnings rule long term

By John Manley

April may not have been cruel this year, but it sure was frustrating. The Dow Jones Industrial Average eked out a new high and the S&P 500 Index consistently traded within a few percentage points of its high; but neither index was able to garner any momentum. First-quarter earnings results were good enough to match the patterns of the past several quarters, but here again, there was no clear breakout to the upside.

A lot of swooning with lots of recoveries

Blame it on the weather or blame it on the Russians—just don’t blame it on the Fed or earnings. Both still seem to be very supportive of an upwardly biased equity market. The Fed may be tapering but it is far from tightening. Investors must remember that tapering, and even the first few rate hikes, from the Fed should not be considered tightening. As long as the Fed wants to encourage economic growth (and we guess that will be for a while), monetary pressure should remain benignly supportive of higher stock prices. Meanwhile, as mentioned above, earnings continue to rise and surprise to the upside (on balance). Earnings may not have the importance of the Fed when it comes to short- to intermediate-term equity performance, but the refusal of earnings to swoon when investors expected they would has been helpful to equity performance.

Ukraine remains a bit of a cloud on an otherwise happy horizon, but it does not have to be a market killer. The interruption of gas supplies to Western Europe or a breakdown in world trade would be potentially calamitous events. However, as long as Russia hunts like an anaconda and not like a viper, the crisis that might cause these eventualities may not appear.

The returns on stocks last month were not at all bad. The S&P 500 Index may have gyrated through the period, but it ended April 0.7% higher. The Dow Jones Industrial Average hit an all-time high at month-end, but its gain was only 0.9%. (Only may be a somewhat misleading word here; 0.9% monthly compounds to more than 11% annually. Perhaps we are all a bit spoiled by the luxurious returns of 2013.)

Speculative growth shakeout

Big, high-multiple growth stocks had a bit of a re-rating. The tech- and biotech-heavy Nasdaq Composite fell 2.0% during the month. While a bit disconcerting, it is worth noting that the prior growth booms have seldom ended in a value crunch. Usually, the real damage does not occur until the fundamentals fall.

Despite the hiccup in big-cap growth, the equity market did narrow in April. The equally weighted Value Line Composite Index slipped 1.7% arithmetically and 2.0% geometrically. The Russell 3000® Growth Index declined 0.3% and, not surprisingly, underperformed the Russell 3000® Value Index (up 0.7%).

Among the sectors, two stood out. Energy, which we perceive to be undervalued, led with a 5.2% gain in the month. Utilities, which we have recommended underweighting, were a close second with a 4.2% rise. We suspect that the latter was a flight to safety that will not continue. Industrials, which we see as a play on a prospective hydrocarbon build-out, outperformed with a 1.6% gain.

At the bottom of the heap was the financials sector, with a 1.5% drop. We suspect that a difficult regulatory environment is beginning to take its toll. Health care, which had been a standout in the past several years, slipped 0.5% as investors shied away from a number of high-growth stocks.

A diverse world of returns in international markets

Overseas, results were mixed. Resource-oriented markets did well as events in Eastern Europe drove energy prices higher. Norway gained 3.4% and Canada added 2.4%. Western Europe was mixed. The U.K. gained 3.1% as economic activity there showed signs of improvement. France advanced 2.6%, but both Germany and Italy trailed peers with a 0.5% gain. The peripheral European markets suffered from the flight to quality, and Ireland and Greece dropped 1.7% and 7.8%, respectively.

Emerging markets continued to sag. For obvious reasons, Russia was the worst, with a 5.7% decline in value. China and India were both lackluster, with -0.3% and +0.1% changes, respectively. Latin America did better than most: Argentina continued to rebound and gained 6.4%, and Brazil also participated, adding 2.4%.

We suspect that April will go down in the books as a somewhat aberrational month. Cold weather in the U.S. and military and political tension in Ukraine probably restrained what otherwise might have been a good showing. The latter issue may linger, but we believe that the forces that moved stocks last year—liquidity and earnings—still remain in a positive mode.

Fixed income: Three surprises so far

By James Kochan

As 2014 began, there were many warnings that “bonds could get killed” in the months ahead. Instead, most sectors of the bond market have recorded very good returns thus far this year. That is the first surprise. The second surprise might be that the high-yield market has not outperformed the investment-grade corporate market.

The municipal market had the best monthly and year-to-date returns, as it continues to recover from a difficult 2013. The seasonal weakness often seen around the April 15 tax date did not appear in 2014. The rebound has been especially strong for the A-rated and BBB-rated credit segments. The average return from the A/BBB indexes is 7% thus far in 2014, versus an average return of 4% from the AAA/AA indexes.

The strong performance of the investment-grade corporate market was also led by the weaker credits. The 4.9% year-to-date return of the BBB credits was 170 basis points (bps; 100 bps equals 1.00%) better than the return from AA credits. That BBB performance helped the investment-grade market produce better returns than the high-yield market. In fact, the BBB returns were greater than the returns from the CCC-rated and weaker high-yield segment. In April and in all of 2014, the CCC credits did not perform better than the BB credits, perhaps because the CCC sector spreads to Treasuries have become sufficiently narrow to prompt portfolio managers to underweight that segment.

Emerging markets dollar-denominated debt also outperformed domestic high yield in April and year to date. Investment-grade international bonds did not outperform in April but have recorded slightly better returns than the Barclays U.S. Aggregate Index thus far in 2014.

A third surprise this year would be the impressive returns from the longest Treasuries. The yield on the 30-year bond has declined 50 bps since January 1, due in part to strong buying by foreign investors. Unsettled conditions in Ukraine appear to have rekindled the safety bid for Treasuries. Thus, note and bond yields are lower now than they were before the Fed started reducing its monthly purchases of those issues.

At this time a year ago, market yields were at their 2013 lows. Then, from May 1 to late August 2013, the yield on the 10-year Treasury note rose from 1.6% to 3.0%. Not surprisingly, the effects of that correction are still seen in the 12-month total returns for most markets. The 10- and 30-year Treasuries had 12-month returns of -5.0% and -7.7%, respectively. The entire Treasury market had a 12-month return of -1.9%, and Treasury Inflation-Protected Securities had a 12-month return of -6.0%. But, those markets that offer greater coupon income have fared much better. High-yield and BBB corporates had 12-month returns of 6.3% and 1.6%, respectively. Despite a severe setback last year, the 12-month return for the municipal market is not negative but rather a gain of 0.5%. These returns are another example of the ability of better coupon income to overcome the negative effects of price weakness over longer holding periods.

Table 1: Year-to-date bond market total returns (%)
Index name 2011 2012 2013 Q1
Broad Market Index 7.80






Corporate 7.51



























High yield 4.50













International bond (ex U.S.)







Emerging markets (dollar denominated)







5-year Treasury







10-year Treasury







30-year Treasury







Source: Bloomberg L.P.
Past performance is no guarantee of future results.

Asset allocation

By Brian Jacobsen

Investment horizons

For investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next three months, we think investors may still be rewarded by looking at higher-yielding fixed-income investments as well as equities, whether growth or value.



Global equities still look attractive from a valuation perspective. There are risks, as the economic recovery is still middling at best. But pessimism is already priced into stocks, especially European and emerging markets equities. Commodity-oriented emerging markets could get cheaper, while manufacturing-oriented emerging markets could continue to recover.


Value versus growth

Choosing between value and growth is like choosing between walking to the store and breathing. Why not both? We think pessimism about the future—of which there is plenty—has contributed to mispriced growth opportunities that blend value and growth characteristics.


Large caps versus small caps

Large-cap companies are probably better positioned for global growth than small-cap companies. That doesn’t mean small- and mid-cap companies should be ignored. However, we think it’s more important to be discerning about the economic exposure of a company rather than judge it solely on its size.


Fixed income

Based on our economic outlook, we believe interest rates are likely to remain low for the balance of the year and next year. This presents an opportunity for investors to take on additional duration and credit risk, but we prefer more credit risk to more duration risk. Provided the economy doesn’t dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues would.


Asset allocation summary table*

Equity recommendations

Neutral positioning is the percentage of market capitalization meeting the classification criteria of a broad market index


Fixed-income recommendations

Neutral positioning is 50%

The bottom line

Although the markets were rough in the first quarter, it was still profitable to ride through it, whether in fixed income or equities. That may be how the rest of this year is: rough but rewarding for those who ride through it. Earnings are still looking good for corporations, the economy is bouncing back from the winter doldrums, and central banks around the world are staying very accommodative. Those should be good omens for the markets.


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